Saving and Investing

Lecture 4
Stock Market Growth (2019 update)
Dow Jones Industrial Average (DJI: Dow Jones Global
Indexes)

The stock market has been on the rise the last ten years post-
recession.
Stock Market Swings
Dow Jones Industrial Average (DJI: Dow Jones Global
Indexes) during the May 6, 2010 flash crash
Stock Market Swings
Dow Jones Industrial Average (DJI: Dow Jones Global
Indexes) on February 6, 2018
Historical bond yields
The cash flows paid by Treasury and investment grade bonds are easy
to predict (except in cases of default, the cash flows will equal the
contractual coupon payments). The primary driver in the value of a
bond is the yield demanded by investors. The chart below shows
historical bond yields over time.
Bond Yields

Source: Federal Reserve of St. Louis Economic Data (FRED)

Common financial investment products
There are many investment products and asset classes
available to consumers and investors. Some of the most
popular are:
Ÿ Bank savings accounts and certificates of deposit (CDs).
Ÿ Corporate or government bonds.
Ÿ Common stock.
Ÿ Mutual funds, including index funds
Ÿ Hedge funds.
Primary and secondary markets
Many financial assets, after they are first issued, can be sold
in the secondary market:

Ÿ Secondary market: Market where assets that are issued in

the primary market can be bought and sold
Ÿ Ex: NYSE
Ÿ Most government bonds have efficient secondary markets

Ÿ Having secondary markets increases the liquidity of an asset

Ÿ Easy to sell or buy
Savings accounts and CDs
Savings accounts and CDs
Ÿ Savings accounts at a bank are one of the more ubiquitous
savings products (though not everyone has one!).
Ÿ Savings accounts are convenient because the savings can be
withdrawn on demand without any fees.
Ÿ Certificates of deposit (CDs) are also offered by banks.
Ÿ CDs differ from savings accounts in that they must remain
deposited for a predetermined period (usually 3 months to 5
years) and so cannot be withdrawn on demand without a fee
(generally a number of months’ interest).
Ÿ To compensate savers, banks offer higher interest rates on CDs,
and longer maturity CDs offer higher interest.
Ÿ Savings accounts and CDs at U.S. banks are regarded as safe
investments because the Federal Deposit Insurance
Corporation (FDIC) guarantees all deposits up to a certain limit
(currently $250,000 per accountholder per bank) in the event of a
bank failure.
Savings accounts and CDs
Even for these simple instruments, it is important to choose
wisely

• Location of bank (your time is valuable)

• In addition to banks, consider credit unions

• Interest offered on the account (or the CD), search before you
commit

• Checks for fees (to have an account, normally there are minimum
balances to avoid fees; overdraw fees, etc).
Corporate Bonds and
Treasuries
Bonds
Ÿ Bonds are a loan from the investors to the issuer.
Ÿ When an issuer (either a corporation or a government) sets a
bond issue, investors buy the bonds, which gives them the right to
receive bond payments in the future.
Ÿ Effectively, the issuer receives cash from the investors at issuance.
The issuer then makes payments to the bondholders over time.
This is equivalent to a loan.
Ÿ Because the issuer may default on the bond, investors require that
bonds pay a higher rate of interest than a savings account, and the
greater the risk of default, the higher the interest rate the
bondholders demand.
Ÿ Bonds issued by the U.S. government, or Treasury Bonds, are
considered to be free of default risk, and so offer a lower interest
rate than corporate bonds. However, they offer higher interest than
a savings account because investments may not be withdrawn on
demand.
Treasury bills and discount interest
Treasury bills, or T-bills, are short-term bonds issued by the
U.S. government.
Ÿ T-bills don’t make explicit interest payments and instead are sold at
a discount.
Ÿ The investor purchases the T-bill for less than the face value, or
par value, of the bond, which is what the Treasury will pay the
bondholder when the bill matures.
Ÿ The interest is the difference between what an investor pays for a
T-bill and its face value. This is known as discount interest.
Ÿ For example if an investor purchases $3,000 worth of three-month
Treasury bills for $2,980, then he will pay $2,980 today and receive
$3,000 in three months. The $20 difference is the discount
interest. This corresponds to an annualized return of 2.68%.
Treasury bill auctions
T-bills are sold in an auction at www.TreasuryDirect.gov.
Ÿ Potential investors bid for the bonds by setting their bid at a price
that will give them their desired rate of interest.
Ÿ The Treasury will then sell its bond issue to the highest bidders.
Ÿ For example, you plan to participate in the Treasury’s six-month T-
bill auction and desire an annualized rate of return of at least 3%,
you will be willing to pay up to $985.33 per $1,000 of par:
Time Value of Money

P/Y 1
FV $1,000
N 0.5
PMT $0
I/Y 3%

PV= -$985.33

Ÿ If the Treasury is able to sell the entire bond issue to other bidders
at a higher price, you will not receive any T-bills. Otherwise, the
Treasury will accept your bid and sell you bonds at this price.
Long-term bonds
Longer term bonds, which may be issued by either
governments or corporations, differ from short-term Treasury
bills in that they make explicit interest payments.
Ÿ The periodic interest payments are known as coupon payments,
and are often paid in quarterly or annually. The coupon rate is the
APR at which interest accrues.
Ÿ When the bond matures, one final coupon payment is made and
the issuer also pays the bondholder the face value of the bond.
Ÿ For example, consider a five-year corporate bond that paid
quarterly coupons at 8%. An investor with $100 worth of the bond
would receive $2 coupon payments every quarter ($8 per year) for
20 quarters (five years), and an additional $100 in five years:

$2 $2 $2 $2 $102
Quarter 1 Quarter 2 … Quarter 19 Quarter 20
Treasury bond valuation
Like T-bills, medium-term Treasury notes (T-notes) and
long-term Treasury bonds (T-bonds) are also sold in an
auction at www.TreasuryDirect.gov.
Ÿ Because T-bills make no coupon payments, they are referred to as zero-
coupon bonds. Longer term Treasuries are coupon bonds that make
coupon payments semi-annually.
Ÿ Treasuries with maturities between one and ten years are referred to as
Treasury notes (T-notes) while those with maturities of greater than ten
years are referred to as Treasury bonds (T-bonds).
Ÿ For example, an investor that bids on a ten-year T-bond with a 6% coupon
rate is bidding for the following cash flows per $1,000 par:

$30 $30 $30 $30 $1,030

½ Year 1 Year … 9 ½ Years 10 Years

Ÿ If such an investor required a return of 7% on such an investment, he

would bid $928.94 per $1,000 par.
Treasury bond valuation
Bond valuation is simple with a financial calculator.
Ÿ A ten-year semi-annual coupon bond will have 20 semi-annual payments
(two per year for ten years).
Ÿ If the coupon rate is 6%, the semi-annual coupon payment will be 3% (6%
divided by number of payments per year) of the face value. So for $1,000
of par, the semi-annual coupon payment will be 0.03*$1,000 = $30.
Ÿ The price of the bond, given a desired interest rate of 7%, can be
calculated with the TVM function (note that P/Y is two):
Time Value of Money

P/Y 2
FV $1,000
N 20
PMT $30
I/Y 7%

PV= -$928.94

Ÿ In this case the price is less than the $1,000 face value. A bond may
trade above or below face value…
Bond valuation
Ex. Consider a five-year corporate bond that pays annual coupon
payments of 6%. The cash flows associated with this bond, per $1,000
par, are:

$60 $60 $60 $60 $1,060

Year 1 Year 2 Year 3 Year 4 Year 5

Bond Price
Time Value of Money
The price of the bond rate at 5%, 6%, P/Y 1
and 7% discount rates can be quickly PMT $60
FV $1,000
found using a financial calculator. N 5
I/Y 5.0%

PV= -$1,043.29 (@ 5%)

I/Y 6.0%

PV= -$1,000.00 (@ 6%)

I/Y 7.0%

PV= -$959.00 (@ 7%)

Bond valuation
Ex. (continued)
Discount Rate Bond Price (6% Coupon)
5% $1,043.29
6% $1,000.00
7% $959.00

Note that as the interest rate increases, the bond price declines. Again,
bond prices are inversely related to interest rates:

Price Price of 6% Coupon Bond

$1,400
$1,200
$1,000
$1,000
$800
$600
$400
$200
$0
1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15%
Discount Rate
Pars, premiums, and discounts
Note that, when a bond is discounted at its coupon rate,
the bond price is $1,000 per $1,000 of par.
Ÿ When the interest rate used to value the bond is equal to the
coupon rate, the bond sells at the $1,000 face value, and the bond
is said to be selling at par.
Ÿ When the interest rate exceeds the coupon rate, the price of the
bond is less than the face value, and the bond is said to be selling
at a discount.
Ÿ When the interest rate is less than the coupon rate, the bond’s
price is greater than the face value, and the bond is said to be
selling at a premium.
Ÿ In other words, the coupon rate is not necessarily the interest
rate realized by the investor. When the bond sells at a discount,
the investor will realize a return greater than the coupon rate.
When it sells at a premium, the return will be less than the coupon
rate.
Yield-to-maturity
Corporate and Treasury bonds that have already been
issued trade actively between investors in secondary
markets. Given the price a bond is trading at, an investor
can calculate the implicit interest rate, or yield-to-maturity
(YTM), offered by that bond.

To find the YTM, find the annualized interest rate I/Y that
satisfies the following cash flows:
Face Value
Coupon Coupon … Coupon + Coupon
Period 1 Period 2 … Period N-1 Period N

Bond Price YTM = I/Y, Frequency = Coupon Frequency

Yield-to-maturity
Ex. A five-year corporate bond that pays quarterly coupons at 8%
currently has three years left to maturity. It sells at $1,010 per $1,000
par. The cash flows on the bond are:

$20 $20 … $20 $1,020

Quarter 1 Quarter 2 … Quarter 11 Quarter 12

$1,010 YTM = I/Y, Frequency = 4

And the YTM of this bond is 7.62%:

Time Value of Money

P/Y 4
PV -$1,010
FV $1,000
PMT $20
N 12

I/Y= 7.62%

Note that the YTM on the bond is different than its coupon rate!
Historical bond yields
The cash flows paid by Treasury and investment grade bonds are easy
to predict (except in cases of default, the cash flows will equal the
contractual coupon payments). The primary driver in the value of a
bond is the yield demanded by investors. The chart below shows
historical bond yields over time.
Bond Yields

Source: Federal Reserve of St. Louis Economic Data (FRED)

Common Stock
Common stock
Ÿ Stock represents a proportional ownership stake in a
corporation. When an investor holds a share of stock in a
company, that investor is a partial owner of the company.
Ÿ As a partial owner of a company, a stockholder is entitled to a
portion of that company’s profits.
Ÿ Corporations pay out their profits as dividend payments.
Ÿ Many stocks are publically traded between investors, so an
investor may be able to profit by selling a stock at a higher price
than that at which it was purchased.
Ÿ Stocks entail considerable financial risk. If the company is
unprofitable, dividends may be scarce, or, if the company’s
business prospects may deteriorate, the investor may be forced to
sell the shares at a loss.
Ÿ The riskier the company is determined to be, the higher will be the
expected return investors demand from that stock.
Common stock
The following real-world example demonstrates how stock
ownership works.
Ex 1. The Coca-Cola Company has 4.5 billion shares of common stock
outstanding. An investor that owns one share of Coca-Cola owns
1/4,500,000,000th of the company and so would be entitled to 1/4,500,000,000th
of the company’s profits in any given year.

In 2012Q3, Coca-Cola had about $2.3 billion in profits and paid out about $1.2
billion of these profits to shareholders, in which case each shareholder received
about $1,200,000,000/4,500,000,000 = $0.26 per share in dividends.

The remaining $1.1 billion was invested in Coca-Cola’s business operations

with the expectation that this investment will increase profits in the future and
allow the company to pay its shareholders higher dividends in the future.
Common stock
The next example demonstrates how a business can raise
capital by issuing stock.
Ex 2. A budding entrepreneur plans to start a cake-baking business, for which
she needs $60,000 in capital. The entrepreneur has $30,000 to invest in the
business and two friends willing to invest $15,000 each. The business owner
incorporates the business by dividing ownership of the business into 4,000
shares.

In this case, each share is worth $60,000/4,000 = $15 and the entrepreneur
receives 2,000 shares and each friend receives 1,000 shares.

At the end of the first year, the business generates $16,000 in profits. The
entrepreneur decides to reinvest $8,000, or half, of these profits in the business
and pays out the rest in dividends.

This implies that the dividend is $8,000/4,000 = $2 per share and that the
entrepreneur will therefore receive $2 * 2,000 = $4,000 in dividends and each
friend will receive $2*1,000 = $2,000 in dividends.
Common stock valuation
Existing shares of a company’s stock are often bought and
sold between investors in the secondary market.
Ÿ The stock of large, publicly-listed firms trades on an exchange,
such as the New York Stock Exchange.
Ÿ The price at which a company’s shares transact depends on the
dividends the company is expected to pay its shareholders.
Ÿ Specifically, a stock’s price should be equal to the present
value of its future dividends:

#$ #( #+
!= + + +⋯
1 + ' (1 + ')( 1+' +

Ÿ Unlike payments on a bond, however, dividend payments from a

stock are not known in advance and may vary with business
conditions and management decisions.
Ÿ So, stock valuation requires assumptions about dividends…
The constant dividend model
One model of stock valuation is the constant dividend model,
which assumes the dividends remain constant over the life of
the company. In this case the stock is valued as:

# # #
!= + ) + * +⋯
1 + & (1 + &) (1 + &)

This is an example of a perpetuity, to which the perpetuity

formula may be applied:

#
!=
&
The constant dividend model
The following example demonstrates how to use the
constant dividend model to value stock.
Ex. One of the friends with 1,000 shares in the cake-baking business described
in the last example decides to sell some of his shares.

If the buyer assumes the company will continue to pay $2 per share in
dividends throughout perpetuity, requires a discount rate of 15%, the buyer will
be willing to pay up to $13.33 per share:

$2
!= = $13.33
0.15

If the buyer pays $13.33 per share, and the company does in fact pay $2 per
share in dividends through perpetuity, the return on the buyer’s investment in
the stock will be 15%.
The Gordon Growth Model
In practice, however, the constant dividend assumption may be
inappropriate.
Ÿ The dividends paid by an expanding business may be expected to
systematically grow over time.
Ÿ The Gordon Growth Model assumes dividends grow at a
constant rate g each year.
Ÿ When this is the case, the present value of the growing dividends
can be shown to be:

#$ (1 + () #$ (1 + ()+ #$ (1 + ()
!= + +
+⋯=
1+* (1 + *) *−(

Ÿ Where D0 is the most recently paid dividend. Note that this model
only makes sense for r > g.
The Gordon Growth Model
This next example demonstrates how to use the Gordon
Growth Model to value stock.
Ex. If the $2 dividend paid by the cake-baking business is expected to grow by
3% per year, the company should be valued at $17.67 per share with a discount
rate of 15%:
#$ (1 + () $2 (1.03)
!= = = $17.17
*−( 0.15 − 0.03

Although still a simple model, the Gordon growth model communicates an

important insight about the value of stock: higher expected dividend growth
leads to a higher price.

Even corporations which pay small or even no dividends today may command a
high price if investors expect that the company has positive business prospects
and will be able to expand and pay out large dividends in the future.

If the Gordon Growth Model still does not accurately capture the expected
evolution of a stock’s dividends, an investor may use a more advanced or
specific model…
Share sales and stock valuation
Even if the investor plans to sell the shares in the future, the
formula for valuing a stock does not change.
Ex. If an investor plans to hold a stock for ! years before selling it, the investor
will receive ! dividend payments and the proceeds from the sale of the stock at
time !. In this case, the investor should value the stock at:

%& %+ "+
"# = + ⋯+ ++ +
1+) 1+) 1+)

But the expected price at time ! will simply be the expected present discounted
value of the dividend payments after time :

%+,& %+,-
"+ = + -
+⋯
1+) 1+)

So, the price reduces to the familiar formula:

%& %+ %+,& %+,-
"# = + ⋯+ + + +⋯
1+) 1+) + 1 + ) +,& 1 + ) +,-
Reinvested profits
Often, corporations do not pay out all of their profits as
dividends. They may retain some or all of their earnings for
reinvestment if they think it will be profitable.
Ÿ If the firm reinvests its earnings and achieves a return greater than
that which its investors demand on the stock (the discount rate),
the company creates value for its shareholders.
Ÿ This is why firms, such as some start-ups, with strong growth
potential, may not pay dividends and instead reinvest any profits.
Ÿ However, if the firms investments do not achieve a return greater
than that which the investors demand, the firm destroys value. In
this case, it would be better for the firm to return its profits to the
shareholders so that they can reinvest the proceeds themselves.
Ÿ Sometimes, investors pressure firms into returning retained
earnings to shareholders if they don’t believe the firm has strong
investment opportunities. (For example, the activist investor Carl
Icahn had pressured Apple into returning cash to shareholders.)
Reinvested profits
Ex. A company currently has profits of $10 per share. If the company pays out
all of its profits as dividends, it will not grow, and it’s dividends will be $10 per
share into perpetuity. If investors demand a 10% return from this stock, it’s
share price will be:

# $10
!= = = $100
$ 0.10

However, if it reinvests all of its earnings, it will pay no dividends this year.
Instead, it’s future dividends will increase by the return on reinvested earnings.
Where is the return on the reinvested earnings, the dividends will be:

#) = $0

#* = $10 + $ ∗ $10 = $10 1 + $ ∗

This decision will only increase value if the return on the reinvested earnings
exceeds the 10% return demanded by investors.

We can generalize for longer time periods than 1.

Reinvested profits
Ex. (continued)

Case 1: Return of 20% on reinvested earnings

If the $10 of earnings per share are reinvested in a project with a return of 20%
per year, dividends will increase to $12 per year, starting in the second year.

To find the price of the stock today, first consider the price of the stock one year
from now. One year from now, the stock will pay constant dividends of $12 per
share, so it’s price will be:
$12
!" = = $120
0.10

The price of the stock today is therefore:

*" !" $0 $120

!) = + = + = $109.09
1 + , 1 + , 1.10 1.10
Reinvested profits
Ex. (continued)

Case 2: Return of 5% on reinvested earnings

If the $10 of earnings per share are reinvested in a project with a return of 5%
per year, dividends will increase to $10.50 per year, starting in the second
year.

The stock price in one year will be:

$10.50
!" = = $105
0.10

The price of the stock today is therefore:

*" !" $0 $105

!) = + = + = $95.45
1 + , 1 + , 1.10 1.10
Reinvested profits
Ex. (continued)

When earnings are reinvested at 20% instead of being paid out as dividends,
the value of the stock today increases from $100 to $109, and shareholders
are wealthier. This is because the 20% return on the company’s investment is
greater than the 10% return the investors demand from the company.

But when earnings are only reinvested at 5%, the value of the stock today
decreases from $100 to $95, and shareholders are poorer. This is because
the 5% return on the investment is less than the return investors demand from
the company.

In the second case, the shareholders would prefer that the company pays them
dividends so that they can reinvest the cash themselves.
Common stock valuation
The following lessons should be taken from this stock
valuation section.
Ÿ A stock should be valued at the present value of its future expected
dividend payments. A company with high dividends nearer in the future
should be worth more.
Ÿ This does not mean companies that are currently unprofitable or that don’t
pay dividends are worthless. If they are in a growing phase and can
invest such that they will one day pay high dividends, they may be very
valuable.
Ÿ It does not make sense to blindly invest into “efficiently run” companies
and shun “poorly run” companies. It depends on the price of the stock. If
you can get low profits for a fair price, it is better than overpaying for high
profits. What matters is whether a stock is a good or bad value.
Ÿ Dividends are uncertain. If the dividends are less than you expected
when you purchased the stock, your return will be less than you planned
on. The less certain you are about the dividends, the higher the risk, and
the higher return you should demand, just in case.
Stocks vs. bonds in the short-term
The graph lists yearly returns. Although higher on average, stock
returns fluctuate wildly from year-to-year:
Yearly Stock and T-Bill Returns (1928-2015)
S&P 500 3-month T.Bill
60.00%

40.00%

20.00%

0.00%

-20.00%

-40.00%

-60.00%
1928 1935 1942 1949 1956 1963 1970 1977 1984 1991 1998 2005 2012

Source: Federal Reserve of St. Louis Economic Data (FRED).

Damodaran, A. "Historical returns: Stocks, T.Bonds & T.Bills with premiums." NYU Stern, 2016.
Mutual Funds and
Hedge Funds
Mutual funds
Ÿ Mutual funds are investment companies that purchase stocks
and bonds on behalf of their investors.
Ÿ Mutual funds allow an investor to spread his or her wealth across a
large number of stocks and bonds using a relatively modest
investment (this is known as risk diversification and its benefits
will be discussed in a future lecture).
Ÿ A mutual fund’s investors may also benefit from the expertise of
the fund’s managers.
Ÿ Mutual funds, however, may require large fees. These fees cover
the managers’ salaries and expenses, and these fees will reduce
the overall return the investors realize.
Ÿ Index funds are a special class of mutual funds that offer
diversification benefits while attempting to minimize fees.
Ÿ Instead of spending resources trying to identify outperforming
stocks, index fund managers passively invest in stocks to track
some benchmark (ex. the S&P 500 Stock Index).
Mutual funds and fees
Mutual funds are investment companies that purchase
stocks and bonds on behalf of their shareholders.
Ÿ Each share of a mutual fund is priced at the fund’s net asset value
(NAV), which is the sum of the prices of all the stocks and bonds
held by the mutual fund, minus any debt owed by the fund, divided
by the number of shares in the fund.
Ÿ Mutual fund investors receive the income from the fund’s stock and
bond holdings, and may also profit from changes in the fund’s NAV.
Ÿ The expense ratio is the fund’s annual operating expense,
expressed as a proportion of the fund’s assets, and reduces an
investor’s returns.
Ÿ A front load (or front-end load) is a fee charged to an investor
upon purchasing shares in a mutual fund, and a deferred load (or
back-end load) is a fee charged when an investor sells shares.
Mutual funds and fees
Always consider the fee structure of an mutual fund. High
fees reduce your overall return.
Ÿ Imagine you invest in a mutual fund with a NAV of $24.50 and a
front load of 5% and deferred load of 1%. A couple of months later
you sell your shares when the NAV reaches $25.50.
Ÿ Without the fees, your return would be 4.08%. With the fees, this
becomes a 1.87% loss!
Ÿ Next, imagine that you invest $50,000 in a mutual fund with a 1.5%
expense ratio. If the assets in the fund return 10% per year, you
will have $554,418 after 30 years.
Ÿ If the expense ratio was instead only 0.20%, you would have
$821,612. This is about $267,000 more!
Ÿ The lesson is clear: fees matter because they reduce your returns.
Try to invest in no-load mutual funds with low expense ratios.
Mutual funds and fees
Ex. An investor purchases 100 shares in a mutual fund with a NAV of $24.50.
The fund has a front load of 5% and a deferred load of 1%. A couple of
months later, the investor sells the 100 shares at a NAV of $25.50.

At the NAV of $24.50, the 100 shares will cost the investor $2,450. The investor
must pay an additional 5%, or 0.05 ∗ $2,450 = $122.50, for the front-end load.
The total cost is then $2,450 + $122.50 = $2,572.50.

When the investor sells his shares at $25.50 a share, his $2,550 proceeds will
be reduced by $25.50 because of the 1% deferred load. Thus, the investor will
receive only $2,550 − $25.50 = $2,524.50.

The investor lost 1.87% of his original investment:

. =/ 1+0

. $2,524.50
→0= −1= − 1 = −1.87%
/ $2572.50
Mutual funds and fees
Ex. (continued)

Without the front load, the shares would cost only $2,450. And without the
deferred load, the investor would receive the full $2,550 in proceeds from the
sale. If this were the case, the return would be:

# $2,550
!= −1= − 1 = 4.08%
$ $2450

Fees reduced the possible return from a 4.08% gain to a 1.87% loss!

Fees matter because they reduce returns. Investors may reduce

the brunt of fees by investing in no-load mutual funds, so called
because they don’t charge front or deferred load fees. However,
investors still need to be aware of the impact of the annual expense
ratio on their returns…
Mutual funds and fees
Ex. An investor holds $50,000 in a mutual fund with a 1.50% expense ratio. If
the assets held in the fund return an average of 10% per year for 30 years, how
much will be in the investor’s account at the end of 30 years? How much would
be in the account if the expense ratio was only 0.20%?

Ans. Each year, the investor’s balance will grow by 10% before being reduced
by the 1.50% annual fee. After the first year, the ending balance will become:

$50,000 1.10 1 − 0.0150 = $54,175

And over thirty years, the balance will grow to:

$50,000 1.10 +, 1 − 0.0150 +, = $554,418

If the expense ratio was only 0.20%, the ending balance would instead be:

$50,000 1.10 +, ∗ 1 − 0.0020 +, = $821,612

This is a difference of about $267,000!

Hedge funds
Ÿ Hedge funds are similar to mutual funds in that they actively
manage investments in different assets (including, but not limited
to, stocks and bonds) on behalf of their investors.
Ÿ The primary difference is regulatory. Hedge funds face fewer
regulatory restrictions than mutual funds in how they may invest
their investors assets.
Ÿ Because they face less regulation, hedge funds are considered
riskier than mutual funds and so, by law, are only available to
accredited investors that exceed certain wealth and income
thresholds.
Ÿ Because they are less regulated, hedge fund performance is less
transparent. Past performance reported by the industry is likely to
be biased and suggest higher returns than the asset class has
experienced.
Ÿ Hedge funds often require very high fees.
Hedge funds and fees
Hedge fund fees often exceed those on mutual funds:
Ÿ Hedge funds often charge a management fee and an incentive fee.
Ÿ The management fee is a charged each year as a percentage of
assets under management.
Ÿ The incentive fee is a percentage of profits.
Ÿ For example, “2 and 20” was a common hedge fund fee structure.
Under such a structure, the hedge fund manager charges 2% of
assets under management each year and 20% of returns.
Ÿ If you invest $50,000 in a hedge fund with a “2 and 20” structure
and the underlying assets return 10% per year, your investment
will grow to $274,451 after 30 years.
Hedge funds and fees
Ex. An investor invests $50,000 in a hedge fund with a “2 and 20” fee structure
for 30 years. The assets managed by the hedge fund return an average 10%
per year. How much will be in the investor’s account after 30 years?

Ans. Each year, the invested assets increase by 10%. However, the investor
gets only 80% of these returns, because the hedge fund gets 20% of all profits
as an incentive fee. Therefore, the annual return (before management fees) is
only 8%:

1 − 0.20 ∗ 10% = 0.80 ∗ 10% = 8%

Additionally, the hedge fund collects a 2% management fee, which reduces the
account balance by 2% at the end of each year. After 30 years, the balance will
grow to:

$50,000 1 + 0.80 ∗ 0.10 ./ 1 − 0.02 ./ = $274,451

Index funds and fees
Mutual fund and hedge fund fees can make a large
difference in an investor’s returns:
Ÿ Front- and back-end loads on mutual funds are charged only once,
but the fees can be large.
Ÿ Annual fees, measured by the expense ratio, may be smaller in
percentage point terms, but this expense compounds over several
years, so may have a dramatic effect on an investor’s returns.
Ÿ Both management and incentive fees on hedge funds reduce your
return each year and have a compounding effect over time.
Ÿ This explains the growing popularity of index funds, which
generally have lower expense ratios than mutual funds (expense
ratios of 1-2% are typical for traditional mutual funds, while popular
index funds may charge an expense ratio of around 0.20%).
Funds and fees
The following chart plots the balance growth of $50,000, which gives
the same return, but invested in:
a) A no-load mutual fund with a 1.5% expense ratio
b) A hedge fund with a “2 and 20” fee structure
c) An index fund with a 0.20% expense ratio.

Funds and Fees

Mutual Fund Hedge FUnd Index Fund
$900K
$821.6K
$750K
$600K $554.4K

$450K
$300K $274.5K

$150K
$0K
1 5 10 15 20 25 30
Year

As an early pioneer of index funds, Jack Bogle, once stated…

Jack Bogle on fund fees
Investors need to understand not
only the magic of compounding
long-term returns, but also the
tyranny of compounding costs.

Jack Bogle, Founder and former

CEO of The Vanguard Group
The Efficient Market
Hypothesis
Efficient market hypothesis
Although the fees on actively managed funds are higher
than on index funds, they might be justified by higher
returns:
Ÿ It could plausibly be the case that funds with higher fees
generate higher returns: an especially skilled fund manager
may command a higher salary and this would translate to
higher returns and higher fees.
Ÿ Whether highly paid fund managers are able to generate
higher returns, however, is a source of some controversy.
Ÿ Several studies find little evidence of skill among managers.
Ÿ This is related to an area of economic research known as the
Efficient Market Hypothesis (EMH).
Ÿ The EMH contends that markets are efficient: it’s
prohibitively difficult or costly to consistently outperform the
market or to identify fund managers who can do so.
Efficient market hypothesis
The evidence suggests that it is difficult for investors and
fund managers to consistently outperform the market.
Ÿ Although some funds in a given year will certainly outperform
the market, numerous studies have shown that, on average
across funds and over time, mutual funds do not provide
superior returns compared to a random selection of stocks.
Ÿ Some studies find that mutual funds do exhibit some stock
picking ability, but that any excess return they might provide
is outweighed by the additional fees they charge.
Ÿ Top performing funds in one year are no more likely to do
well in the following year than that year’s poorly performing
funds (and in fact, many studies find they are likely to do
worse…).
Efficient market hypothesis
Charles Wheelan, the author of Naked Economics, describes the EMH
by comparing it to picking the shortest line in the grocery store:

Picking stocks is a lot like trying to pick the shortest checkout line at the
grocery store. Do some lines move faster than others? Absolutely, just as
some stocks outperform others. Are there things that you can look for that
signal how fast one line will move relative to another? Yes. You don’t
want to be behind the guy with two full shopping carts or the old woman
clutching a fistful of coupons. So why is it that we seldom end up in the
shortest line at the grocery store (and most professional stock pickers
don’t beat the market average)? Because everyone else is looking at the
same things we are and acting accordingly. They can see the guy with
two shopping carts, the cashier in training at register three, the coupon
queen lined up at register six. Everybody at the checkout tries to pick the
fastest line. Sometimes you will be right; sometimes you will be wrong.
Over time they will average out, so that if you go to the grocery store often
enough, you’ll probably spend about the same amount of time waiting in
line as everyone else.
Naked Economics, Page 163
Return on different assets
The following table lists the historical nominal returns and
standard deviations (a measure of risk) for some common asset
classes from 1926-2005:
Standard
Asset Class Geometric Mean Arithmetic Mean
Deviation

Large Company Stocks 10.4% 12.3% 20.2%

Small Company Stocks 12.6% 17.4% 32.9%

Long-term Corporate
Bonds
5.9% 6.2% 8.5%

Long-term Government
Bonds
5.3% 5.5% 5.7%

U.S. Treasury Bills 3.7% 3.8% 3.1%

Inflation 3.0% 3.1% 4.3%
Source: A Random Walk Down Wall Street - Burton Malkiel (2007),
page 185; data from Ibbotson Associates.

This table is consistent with our intuition: stocks are riskier than
bonds, with small company stock being the riskiest and short-term
Treasuries the least risky.
Meeting a Savings Goal
Saving for a college education
A child’s college education can be a significant expense. To
ensure that you’re able to meet the expense, plan ahead.
Ÿ In the first lecture, we demonstrated the power of interest
compounding. To save for your child’s $200,000 Ivy League
education, you can set aside about $80,000 when they are born.
Ÿ But for many, it is hard to come up with $80,000 at any given
moment (especially with all the other expenses new children
bring!). It is more manageable to save a little bit each year.
Ÿ If you invest in a combination of stock and bonds that you expect to
earn 5% each year, you could save for your child’s education by
saving $7,109 at the end of each year.
Ÿ Or, if you’d prefer to start today, you can save $6,771 at the
beginning of each year, starting today.
Saving for a college education
Let’s see how to compute the necessary end-of-year
contributions.
This problem has the following cash flow structure:
FV = $200,000
PV = 0 PMT=? PMT=? … PMT=? PMT=?
Year 1 Year 2 … Year 17 Year18

Interest Rate = 5%, Frequency = 1

Where the payment can be solved for using a financial calculator:

Time Value of Money

P/Y 1
PV $0
N 18
FV $200,000
I/Y 5%

PMT= -$7,109.24
Saving for a college education
Now let’s see how to the required contributions when they
are made at the beginning of the year.
This problem has the following cash flow structure:
PV = 0
PMT=? PMT=? PMT=? … PMT=?FV = $200,000
Year 1 Year 2 … Year 17 Year18

Interest Rate = 5%, Frequency = 1

This does not fit the TVM structure that we are used to! In order
to use the TVM function as we have used it, the payments must
occur at the end of each period.

Fortunately, there is a way to change the timing of the periodic

payment on your financial calculator…
Saving for a college education
Now let’s see how to calculate the required contributions
when they are made at the beginning of the year.
With your financial calculator set to beginning-of-period
payments, you can solve for the required annual contribution:

Time Value of Money

BGN BGN
P/Y 1
PV $0
N 18
FV $200,000
I/Y 5%

PMT= -$6,770.71

It only costs $6,771 per year instead of $7,109 if you contribute at

the beginning of each year. This is because, when you contribute
earlier, each contribution gets an extra year’s interest!
Saving for a down payment
Even with a mortgage, homebuyers may still need to
accumulate savings to meet their down payment, and this
may require several years worth of savings.
Ÿ To make a 20% down payment on a $400,000 house, a
homebuyer will need 0.20 ∗ $400,000 = $80,000.
Ÿ If the homebuyer sets aside $1,250 each month in a savings
account earning 3%, it will take about five years to accumulate the
necessary savings.
Ÿ Or, if the homebuyer wants to have enough to make the down
payment in 3 years, he must set aside $2,126.5 a month for three
years.
Saving for a down payment
These values can be found using a financial calculator
(remember to change back to end-of-period payments after
the last problem):

Note that some planners might ignore the effect of interest and
plan to set aside per month for 36 months. This is incorrect and
we see that even with a small interest rate of 3% over a relatively
short period of three years, our future home buyer can save $100
per month.
Today we learned…
ü Savings accounts
ü Corporate bonds and treasuries
ü Common stock
ü Mutual funds and hedge funds
ü The efficient market hypothesis
ü Meeting savings goals